EAST EUROPE'S ENERGY TRADE TAKES NEW SHAPE

Charles Movit
PlanEcon Inc.
Washington, D.C.

Often in the past, Western analysts of global energy demand have treated Eastern Europe as just part of a black box labeled "Communist." Only the net flow of energy to the "non-Communist" world was of any consequence. The region, although primarily a major net importer of energy from the Soviet Union, was a very small net exporter of energy to "nonCommunist" countries based on Polish coal exports, Romanian refined petroleum product exports, and some minor exports of refined products by other East European countries.

The political and economic configuration of Eastern Europe has changed dramatically over the past 2 years, however, and the way in which East European energy relationships are considered will have to change accordingly. With the sweeping transformation of these economies (for the most part, radically in the direction of a market orientation) and the breakup of their unique system of mutual trade, the patterns of energy production, consumption, and trade which have prevailed in the region during the post-war period will also change significantly.

Forecasting the net impact on energy demand in this region of offsetting trends due to economic reform (i.e., renewed economic dynamism vs. decreased energy intensity of aggregate economic output) is a very difficult task. Moreover, there are additional complications introduced by changes in the political system, such as the increased importance of environmental quality in the choice of fuel and production technology due to clearly enunciated concern of the popular political movements with these issues.

Understanding the nature of the political-economic dilemma which impelled the rapid changes in Eastern Europe is essential in identifying the tasks faced by the reformers in the medium term as well as projecting the sorts of changes which will be taking place in the economy as a whole and more particularly in the energy sector. The Communist political regimes which had held sway for decades in Eastern Europe had made an implicit social contract with the populace. In return for a monopoly on political power, the party promised steady improvements in the living standard of the workers.

But, by the late 1980s, it had become very clear that the Stalinist economic model was failing to provide for a sufficient rate of growth in aggregate economic output and hence in the standard of living; thus, the already yawning gap between East and West was widening. This constituted a loss of legitimacy of the claim of the ruling party to its exclusive position and led inexorably to the fall of one regime after another in Eastern Europe.

The successor regimes are seeking to return their countries to a period of economic dynamism. For the most part, they are not convinced that the only way in which this can be attained is through the efficiency gain that would result from the revival of private enterprise as the dominant form of economic activity in Eastern Europe.

INTERFERENCE DWINDLING

With legislative and institutional changes proceeding already along this new path in Czechoslovakia, Poland, and Hungary (and planned in Romania and Bulgaria), the bureaucratic ties which provided for day-to-day interference by the center in production activity are dwindling. The regimes are seeking to rationalize their economies by liberalizing the process of price formation, liberalizing trade, and ending the subsidization of inefficient enterprises. In order to mobilize the power of the profit motive, large state enterprises are being converted to joint stock companies, and the formation of new small and medium-sized enterprises is being encouraged.

While the impact of this transformation on the rate of economic growth in the longer term is certain to be strongly positive, the near term spells significant downturn in aggregate output. The need to replace the old economic order and to stabilize the economies will entail domestic austerity. The extent of the downturn in each country will depend on the effectiveness with which the transformation program is implemented and the initial health of national economies at the outset of the transformation.

To understand why such difficult times are at hand, we must return to the implicit contract between the Communist regimes and their workers. As the leaders and planners became aware of the threat to the basic premise of their system posed by faltering economic performance, they acted in a number of irresponsible ways to try to protect living standards. The consequences of the mismanagement, which differed in severity across the region, are still felt today. They have assumed three forms:

Monetary overhang. Communist leaders sought to keep prices of staple goods for the workers very low and to prevent inefficient firms from failing to avoid the social costs of unemployment. This was accomplished by an elaborate system of huge state subsidies resulting in chronic state budget deficits financed by printing money. Serious disequilibrium in consumer goods markets resulted, eroding incentives to labor.
External debt. A number of these countries sought to borrow in the West to prop up consumption, resulting in heavy per capita debt burdens. Last year, Bulgaria was forced to declare a moratorium on debt repayment and is not on the road to full rescheduling. This has resulted in decreased access to Western credit markets across the board for East European borrowers. The exception is Czechoslovakia, where extremely conservative borrowing policies prevented any buildup of Western debt.
Disinvestment in the domestic economy. To further protect consumption, the burden of macroeconomic adjustment (such as that required by the contraction of available Western credits in the early 1980s) was, to the degree possible, shifted to investment. Thus debts were incurred with respect to domestic productive capital stock, with respect to much-needed infrastructure, both social and economic, and with respect to the environment.

The succeeding regimes must now seek to transform the inefficient, outdated industrial structure, which will require the closing of some enterprises and the elimination of redundant labor. At the same time, they must stabilize the economy by restoring equilibrium in consumer goods markets, cope with burdensome debt service, and begin to reverse the damage to the infrastructure, productive base, and environment caused by mismanagement and neglect of the previous system.

AID, INVESTMENT

The tasks can be made more manageable if there is an inflow of resources to the region in the form of aid and investment from the West. Western investment can bring up-to-date technology and resources to renovate the capital stock and improve the competitiveness of export production.

The long-neglected business infrastructure and service sectors in these countries should also prove to be fertile ground for new enterprises and attractive in some cases to Western investors. For a number of reasons, including low wage costs, a relatively educated labor force, attractive geographic location, and the possibility to gain a foothold in a large, almost untapped potential market, despite the bleak near-term macroeconomic prospects of the transition period, there is significant interest in the countries among Western investors.

For the most part, to date, the size of individual Western investments has been rather small--there is somewhat of a wait and see attitude. It is nevertheless clear that there are some attractive opportunities, and pioneering Western firms are finding that bringing in a Western management team can make a good deal of difference in an East European firm's profitability fairly rapidly.

The attractiveness of individual East European countries to Western investors will hinge on a number of factors which relate to the legal environment and evolving business culture as well as the outlook for political stability and return to economic dynamism. Fig. 1 indicates a preliminary attempt to rank these countries according to the type of criteria cited here.

In seeking a return to economic dynamism, however, East European economic policy makers are going to find the slowdown of systemic transition and stabilization exacerbated by three factors. These factors will affect their traditional export markets and terms of trade.

TRADE SHOCK

The first shock is arising from the dismantling of the CMEA (or Comecon) trading system. The countries of Eastern Europe have primarily exported manufactured goods to the Soviet Union in return for Soviet exports of energy and other key raw materials (see table). These exports of energy were for inconvertible rubles at special intra-CMEA prices.

The price formula involved a 5 year moving average of world market prices. If the price of oil to Eastern Europe were to be converted to dollars at the official Soviet exchange rate as of 1989 (before the sharp increase in the price of crude due to the invasion of Kuwait), the East Europeans would have been paying over $24/bbl for crude oil. However, because the East European exports of manufactures which paid for the oil were grossly overpriced in intra-CMEA trade, the realistic dollar price of Soviet oil to Eastern Europe was much lower.

If we used a cross-exchange rate of the ruble against the dollar based on the costs in an East European economy of earning 1 dollar and 1 ruble in foreign exchange through trade, that rate would have been in the neighborhood of 1 ruble = 50 cents rather than an official Soviet rate near $1.60. At the realistic rate, Eastern Europe paid an average of less than $7.50/bbl of Soviet crude in 1989. Fig. 2 indicates the share of actual expenditures--with rubles converted to dollars at a realistic exchange rate--in what the energy bill for each country would have been in 1989 at world market prices.

Beginning in 1991, this has changed. Eastern Europe is required to pay world market prices for Soviet oil with bilateral trade to be settled in hard currency. This will amount to a huge shift in terms of trade in favor of the Soviet Union. It will create severe balance of payments pressures on these economies at a point at which they can ill afford them.

The Soviets have reached some agreements with East European trade partners to help ease the impact of the transition. In the cases of Hungary and Czechoslovakia, ruble surpluses accumulated in bilateral trade with the Soviet Union in the past will be converted to dollar debt of the Soviet Union and used to off set some of the anticipated deficits in the future. Given the very sharp shift in their terms of trade, however, the new assets are going to be rapidly used up. In fact, the pace at which these assets in the Soviet Union can be drawn down to settle bilateral trade accounts is a current point of disagreement.

The rapidly reforming economies of Eastern Europe, believing that in several years' time they can make considerable strides in recovering their international competitiveness, are anxious to draw down all of these assets in the next 2 years in order to help cushion the shock to their domestic economies in a time of transition.

The Soviet Union, on the other hand, is likely to continue to insist that these East European assets be used only over a longer period of time, say 5 years, to offset bilateral deficits with the Soviets.

The Soviet Union is not in any shape to postpone so large a share of its gains from shifting terms of trade over the next 2 years.

Further negative impact on aggregate economic activity in Eastern Europe over the medium term will result from the simultaneity of the downturns in these economies. They are, after all, for the most part each others' major trading partners.

Domestic austerity in one economy will depress its demand for imports from its neighbor, with a downward spiral of economic activity in successive iterations a distinct possibility.

ENERGY IMPLICATIONS

The macroeconomic and trade developments outlined here suggest a set of (often mutually offsetting) implications for the East European energy sector. While rates of energy production are likely to decline with the economic dislocation together with the deliveries of relatively affordable Soviet energy, two factors will mitigate the apparent shortfall.

First, the economic downturn will mean a reduction in the quantity of energy consumed, although less than in proportion to the downturn in economic output, if we are to judge by previous experience (there are large fixed energy requirements in any economy).

Second, the transformation to a market-oriented economy will mean a rationalization of the energy picture. Higher relative prices for energy will mean savings in direct use of energy in production processes. They also will cut indirect energy use, such as by reducing the excessive consumption of other materials, such as energy-intensive metals.

As these economies restructure away from the inappropriate output mix dictated by the Stalinist development model, the profile of output will shift from energy-intensive heavy industrial production in favor of light industrial goods and services. Over the medium term, a considerable share of any increase in the value of aggregate output of the economy may well result from improved quality of output rather than merely from increased quantity, further altering the relationship between national product and energy consumption.

Analysts have just begun to examine the issues involved in the rationalization of the energy systems in Eastern Europe under a regime of radical economic reform. At PlanEcon, we have looked at some depth into the question of what technological/structural change in the Soviet Union might mean in terms of energy saving in an effort to forecast Soviet energy consumption and thus net exports (see an article by R. Caron Cooper in PlanEcon's Soviet Energy Outlook, March 1991).

Some of the inferences should relate in some degree to Eastern Europe as well, since many of the structural problems in these economies were a gift from the Soviet Union as part of the Stalinist development model.

It should first be noted that the share of industry in energy consumption under this model is very high from an international perspective. This should decline, not only as the profile of industrial output shifts toward the products of light industry but also in favor of transport, services, and housing.

For industry, there is obviously great potential for energy saving because of the past persistence of very unrealistic relative prices for energy and the fact that industrial enterprises did not operate under meaningful budget constraints, seeking to maximize output rather than profit and relying on subsidies from the state budget to close financial shortfalls.

Soviet steel production is a prime example of a branch of energy-intensive heavy industry.

A rough comparison with developed Western economies shows that consumption of steel per unit of aggregate economic output in the Soviet Union is much higher--about four times that in the United States.

A number of important characteristics, relating primarily to available technology and the assortment and quality of products, dictate the heavy claim of this branch of industry on energy supplies:

Because of the lack of sufficient electric arc furnaces, there are excessive requirements for pig iron (and thus for coking coal).
Considerable waste of crude steel occurs in the output of rolled products.
There is an appropriate mix of steel products, with insufficient thin steel sheet, for example, so that thicker sheet is substituted.
Because of neglect of spare parts production and distribution, a sizable proportion of machine-building output is purchased by enterprises merely to be scavenged for spare parts.
Clearly, all this waste in the use of metal has important implications for the tonnage entering the transport sector and hence its fuel demand as well.

Similar analyses can be performed in other branches of East Bloc industry, such as aluminum, cement, paper, and electric power production, as well as transport and other nonindustrial sectors.

Some anticipated changes, however, will have impacts in the opposite direction. For example, the long overdue expansion in the fleets of trucks and private autos in Eastern Europe is certain to increase demand for motor fuels.

But the net effect of rationalization on these economies is certain to be a significant reduction in the energy intensity of economic output.

ENVIRONMENTAL CONCERN

While the economic slowdown and improved energy efficiency we foresee promise to help to ease the East European energy shortfall, a new and important consideration in Eastern Europe will serve to complicate matters: dramatically heightened and highly visible concern of the population with the quality of the environment.

The new political realities mean that most of the new leaderships must respond to these concerns--a commitment to improve environmental quality has been adopted by most of the post-Communist political movements in Eastern Europe in recognition of strong grassroots concern. Already, these concerns have led to the cancellation of a major hydroelectric project and the trimming and stretchout of nuclear energy plans.

The major environmental problem on the energy front in the region stems from heavy reliance on very low quality, high sulfur lignite to generate electric power. East European concern about the environmental impact of emissions from lignite burning (serious degradation of air quality and widespread damage from acid rain) is reinforced by West European positions on what is of necessity a shared problem.

East European nations will have to move rather rapidly to curb the burning of low grade lignite. In 1990, we estimate that low quality coal (mostly high sulfur lignite) accounted for more than one half of primary energy production in Bulgaria, Czechoslovakia, eastern Germany, and Yugoslavia.

Environmental and safety concerns will also affect the future of nuclear energy in Eastern Europe. In recent years, two facts have become evident to East Europeans about nuclear energy: First, some Soviet-designed reactors pose serious safety problems, and in general, the Soviet Union and Eastern Europe has been slighting efforts to achieve safer nuclear energy; and, second, as in the West, it became clear that nuclear power is a high cost solution to meeting energy requirements.

Nevertheless, while local feelings may be quite strong in opposition, most East European countries cannot afford to abandon altogether their nuclear power programs in light of their rather poor endowment of fossil fuel resources, particularly hydrocarbons. Efforts are likely to be channeled to assuring the safer operation of existing facilities, with the expansion on hold until designs can be altered to significantly raise safety factors. The Finns have developed some new safety systems which have improved the security of their Soviet-designed reactors and have begun to work with the East Europeans on nuclear power safety projects there.

SOVIET MARKET OPENS

The major news for Western energy companies in recent economic and trade developments in Eastern Europe is that a formerly captive Soviet market for energy is opening up.

With trade between Eastern Europe and the Soviet Union at world market prices and settled in hard currency, there is no strong incentive for Eastern Europe to take Soviet energy, except that the infrastructure is already in place. Moreover, the East Europeans, having suffered sharp cutbacks in Soviet deliveries in recent months, now look at the Soviet Union as an unreliable supplier and will actively seek to diversify their sources of energy for that reason alone.

On the other hand, economic downturns in Eastern Europe coupled with rationalization of their energy use will mean that the region's demand for energy will not be very dynamic into the medium term. But strong environmental concern will require a number of these countries to seek to replace significant shares of domestic energy production, and their relatively poor domestic energy resources mean they will have little alternative to replacing this with imported energy.

In the longer run, Eastern Europe will be viewed as just one part of an expanded European energy market. Nonetheless, for a variety of reasons, including historical and geographic, it is likely that the Soviet Union will continue to play a significant role as energy supplier in the region.

The major question in regard to how significant that role might be is the likelihood that Western energy firms will become involved in energy production in the Soviet Union (which could help to stem the decline in Soviet energy production) and thus support a higher level of net energy exports.